What You Own: Portfolio Metrics and Holdings

{ Euclidean Q1 2013 Letter }

With our letters, we aspire to keep you connected with our investment process and what you own as a Euclidean Investor. We focus on these topics because they contain the most relevant information for evaluating Euclidean’s prospects for future returns. Our recent letters have focused on our investment process and why we believe it is historically sound. This letter focuses on what you own as a Euclidean Investor. Specifically, we discuss the aggregate fundamentals of our portfolio, start a practice of sharing our ten largest positions, and review one controversial industry in which we have invested.

Context

It would not be a genuine Euclidean letter without talking at least briefly about how we invest. We hope that doing so provides a helpful context for considering the portfolio metrics and positions that follow.

Our investment process, which was formed from taking an unbiased look at the past, systematically applies what might sound like an obvious principle: that sound, long-term investing requires purchasing shares in companies with historically strong fundamentals when their shares are available at low prices. In practice, however, low prices for historically strong companies emerge only when the market becomes pessimistic about those companies' future prospects.

We are comfortable taking this contrarian approach to investing because it aligns with what our research found to be fruitful over the long-term and conforms to our understanding of how markets work. With individual companies and industries, as with the overall economy, we observe that the environment cycles between good and bad times, and that investors often overreact to these cycles. When times are good, investors act as though things can only get better and pay premium prices for a company’s shares. When times are bad, investors act as if things can only get worse and often sell companies’ shares at significant discounts to their underlying worth.

For a high-resolution picture of how investors behave in response to these cycles, think back to the end of 1999. Remember the optimism surrounding technology companies and the pessimism surrounding the tobacco industry. Technology companies had shown tremendous gains and, with the Internet revolution, their potential for growth seemed limitless. Conversely, tobacco companies seemed to have an uncertain future as they were overwhelmed by intense litigation and a withering regulatory assault. In this instance, you would have benefited from sensing danger at the top of the technology cycle and opportunity at the depths of the tobacco industry’s travails. If you had invested in the technology-laden Nasdaq Index, you would still be underwater thirteen years later. If you had invested in tobacco companies during their darkest days, however, you would have grown your investment several-fold.

This dynamic and example are relevant to our discussion. At the bottom of a cycle that impacts a given company or industry, you sometimes find a convergence of compressed profit margins and – because of corresponding investor pessimism – very low valuation multiples on already weakened earnings. Powerful gains emerge from this convergence when a company’s margins begin to reinflate toward normal levels or if the company reapproaches a market-level valuation multiple over time. The real wins come when both reversions occur at the same time.

Our Portfolio – Aggregate Look-Through Earnings

In late 2008, we came into the office nearly every day and found the markets, and our positions, sharply falling in price. To maintain our sanity, we sought a method for keeping track of what the fund really owned. We do not mean the positions we held and their prices; that information was already front and center. Rather, because we believe a company’s stock price will eventually reflect that company’s financial results, we wanted a touchstone for monitoring the real business value on which the Fund had a claim. This caused us to create our first portfolio look-through earnings report.

A good analogy for how we think about look-through earnings is to think of a CEO of a business with 30 divisions. That CEO would pay attention to the performance of each division and, if he’s good at what he does, thoughtfully allocate capital to those divisions where incremental cash would earn the highest prospective returns. At the end of each year, his scorecard would be the consolidated financial results of all divisions. When that scorecard shows long-term cash flows increasing at a rate exceeding inflation, the company’s business value is growing and his long-term shareholders’ wealth is being enhanced.

This analogy resembles what Euclidean monitors and hopes to see on an ongoing basis. At Euclidean, we own shares in approximately 30 companies. If a given portfolio company has a $300M market value and we own $3M worth of its shares, then we own 1% of that business. So, to create our consolidated look-through financials, we take 1% of that business’s revenue, cash, debt, earnings and so on, and combine that with our pro-rata share of our other holdings’ financials. These look-through earnings help us understand the same things that our fictional CEO with 30 divisions would care a lot about: How much annual, discretionary cash flow do we have? How does our balance sheet look? Is the business growing?

Moreover, much like our imagined CEO who might acquire or divest a division, we seek to sell a position when its business value is reflected in its current price and then establish a position in a new company where its underlying business value is being offered at an attractive discount. Therefore, our look-through earnings report shows not only how our current holdings’ underlying businesses are performing but also shows how well we are managing the portfolio to move capital into holdings where we can establish a claim on larger expected future cash flows.

Our current look-through earnings report (see page 6) is interesting. First, note the large difference in the yields on trailing four-year average pre-tax earnings. Part of this difference is because the more recent, trailing 12-month pre-tax earnings of our portfolio companies are about 40% lower than their four-year average while the SP500’s earnings are about 10% higher. This has occurred even as our portfolio companies have grown revenues by about 20% over the past four years and the SP500’s top line has remained flat.

Our perspective on these numbers is that the SP500 is operating at historically rich margins and receiving a fulsome valuation on those earnings. Investors seem to ‘like’ the recent earnings growth, even as it comes from increased productivity and not from new sales, and feel optimistic that good times are not over for the SP500’s constituent companies. Our holdings, on the other hand, are operating at compressed margins versus their long-term averages even as they have continued to grow revenues. Moreover, our holdings are valued at discounted multiples to earnings. This discount to the market’s multiple is more than 50% when measured on trailing twelve-month earnings; it is closer to a 75% discount when measured on trailing four-year earnings. The market seems to expect our portfolio companies’ recent challenges to deepen and persist.

Consider this situation in the context of the prior section. We have positions in companies that collectively have the staying power of more cash than debt, compressed profit margins, and low valuation multiples. As our holdings move out of the troughs of their respective cycles, we expect their margins to reinflate. We also expect that the market will pay a higher multiple when recent earnings begin to show growth. Should this occur, we will look back fondly on this period as a time when substantial returns were in our future.

Euclidean’s Largest Holdings as of February 15th 2013

With this letter, we are establishing a practice of sharing our 10 largest positions. We are sharing this information because a growing number of you have expressed an interest in talking through individual positions as a means of better understanding how our investment process seeks value. Also, Euclidean aspires to grow such that next year our size would require us to disclose, via 13F filings, our positions 45 days after the end of each quarter. We feel that adopting a practice now of disclosing our largest positions with a similar lag will lead us nicely into our new requirements in the future.

We are available to discuss these holdings with you at your convenience. We are happy to explain both why our models have found these companies to be attractive as well as our sense of why the market has been pessimistic about their future prospects.

Euclidean’s 10 largest positions as of February 15th 2013 (in alphabetical order)

Aeropostale - ARO

Almost Family - AFAM

Amedisys - AMED

DeVry - DV

GameStop - GME

G-III Apparel Group - GIII

Lincoln Educational Services - LINC

Mantech International - MANT

Synnex - SNX

True Religion Apparel - TRLG

Commentary on the For-Profit Education Industry

You will notice that two of our ten largest positions (DeVry and Lincoln Education) are for-profit education institutions. We thought it might be helpful for you to understand why our investment process identified these candidates as worthwhile investments and also why we are optimistic about their prospects.

The for-profit education industry has been undergoing dramatic change during the past several years. As the economy turned down and the employment market weakened, the industry has faced two major challenges. First, enrollments have declined as fewer students feel comfortable taking on the financial commitment to attend these schools in light of the weak job market and weak post-graduate employment prospects. Second, as fewer graduates have been able to find jobs, an increasing percentage of students have become delinquent on repaying student loans. This second point has been a source of significant reputational damage to the industry. Industry critics believe that these schools have generated excess profits from federally subsidized student loans while underpreparing students to pursue meaningful careers. The consequence for the industry has been a series of intense new regulatory requirements. For example, a for-profit school now risks losing eligibility for Title IV programs, through which students receive federally subsidized student loans, if it cannot document that a high percentage of its graduates find jobs and repay student loans.

To survive in this new and challenging environment, for-profit education institutions have initiated significant changes to their operations. They have changed their recruitment practices, introducing tighter application criteria, pre-enrollment testing, and trial periods to increase the probability that new students will ultimately graduate from their programs and find jobs. They have closed campuses and shut down programs in subjects where students have weak job prospects upon graduation. They have pursued tighter partnerships with companies to ensure their educational programs align with employer needs.

This period of adjustment, capacity rationalization, and declining enrollment has impacted for-profit educators’ financial results. Across the industry, revenues have declined and margins have severely compressed. This, coupled with a hostile regulatory environment, has caused for-profit educators’ stock prices to drop from 50%-90% over the past three years. Most companies in this industry are now very inexpensive in relation to their previous earning power and, in some instances, in relation to their balance sheets. Certain for-profit educators now have market values that are less than their tangible book values. Some are trading at a multiple of one-times the pre-tax earnings they recently generated in a single year.

It should be obvious why Euclidean’s models see an opportunity with for-profit educators – this industry is inexpensive in relation to trailing earnings, has shown strong long-term revenue growth, and has historically generated high returns on invested capital. Take Lincoln Educational Services as an example. Since 1946, Lincoln’s programs have prepared students to become automotive technicians, to run medical equipment, to repair HVAC systems, and to secure jobs in other skilled trades. In Lincoln, our models see a company that continues to generate cash even as its profitability has eroded due to lower enrollments and impairment charges associated with shrinking its campus footprint. Our models also see a company that has, over the long-term, consistently generated operating margins of 8%-10% and realized peak margins of 19% in 2010. If our models were to ‘speak’, they might say à in light of similar situations observed in the past, this company looks likely to stabilize revenues around the $400M it delivered in 2012 and eventually return to a normal level of profitability. If it does this, then it has the potential to generate at least $30M in annual pre-tax earnings and merit a market valuation materially higher than its current $130M valuation.

Even though Euclidean’s decision to own shares in Lincoln Education and other for-profit educators is model-driven, we thought we might share our own views regarding these investments. We are happy to have positions in this industry. We believe that markets routinely underappreciate that cycles persist and how quickly profit-seeking enterprises can make adjustments when their environments require them to change. We have witnessed in other companies, and experienced in our own prior business, how challenging environments, such as the one confronting for-profit educators today, often create lean and focused survivors that demonstrate surprisingly favorable operating leverage when growth returns.

We anticipate that the debate about the merits of secondary education, federally backed student loans, and gainful employment will continue during the years ahead. We imagine the possibility, however, that as the debate begins to shine a light on public (non-profit) universities’ imperfect track records of producing employable graduates, surviving for-profit institutions will be well into a very important and valuable transition. They will be uniquely focused on programs that foster the skills employers covet most and will have more than a three-year head start documenting the successful outcomes of their students. We believe that many of these for-profit educators will see margins recover, eventually receive normal multiples on earnings, and prove that their current share prices were too low.

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We greatly value the privilege of managing a portion of your assets and want you to be an informed Euclidean Investor. We are available to discuss the content shared here, the individual positions in our portfolio, or any other questions you might have. Please call us at any time. We enjoy hearing from you.

We share these numbers because they are easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale.[1] [2]

It is important to note that Euclidean uses similar concepts but different measures to assess individual companies as potential investments. Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth. Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade-offs between measures, and so on. These numbers should, however, give you a sense of what you own as a Euclidean Investor. In general, higher numbers for these measures are more attractive. The key measures are:

Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields. Earnings Yield reflects a company’s past four-year average earnings before interest and tax, divided by its current enterprise value (enterprise value = market value + debt – cash).

Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) in the business. At its highest level, this measure reflects two important things. First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders. Second, it indicates whether management has good discipline in deciding what to do with the cash it generates. For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy, will show lower returns on capital than businesses that do the opposite. Return on Capital reflects a company’s four-year average earnings before interest and tax, divided by its current equity + long-term debt.

Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others. High numbers here imply that the company owns a large portion of its figurative “house” and, all else being equal, indicates a better readiness to weather tough times.

Revenue Growth Rate – This is the annualized rate a company has grown over the past four years.

[1] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials. That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on. Then, it sums those numbers with its pro-rata share of all other portfolio companies. This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures presented here.

[2] The S&P 500 measures are calculated in a similar way as described above. The market values, revenue, debt, assets, earnings, etc., for each company in the S&P 500 are added together. Those aggregate numbers are then used to calculate the metrics above. For example, the earnings yield of the S&P 500 is calculated as the total average four-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).

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